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Until recently, Wendy’s (NASDAQ: WEN) was one of the market’s top growth stocks. The stock soared from $8 per share to over $11 per share in 2014, as investors hailed the company’s turnaround and aggressive franchising strategy.
However, the past few months have been a completely different story. The stock is hovering around the $10 mark, as it seems the market is no longer thrilled with the company’s strategy.
The picture got even more complicated when Wendy’s unveiled a mixed earnings report on Wednesday. Here’s a rundown of Wendy’s second quarter and why the stock market was hungry for more growth.
Investors Not Satisfied
Wendy’s served up 2.4% growth in company-owned same restaurant sales last quarter. Same restaurant sales is a metric that evaluates growth at restaurants open at least one year. This figure handily beat analyst expectations, which called for 1.6% growth, according to analyst estimates compiled by Bloomberg.
System-wide comparable sales, which include the company’s franchised restaurants, grew 2.2% last quarter, which beat the 1.6% rise expected by analysts.
That was the good news. The bad news was that Wendy’s profits came up short. Adjusted earnings per share clocked in at $0.08, falling slightly below analyst forecasts for $0.09 per share.
Adding to the uncertainty was that even though same-restaurant sales are growing, total sales are still declining. Total revenue at Wendy’s fell 3.3%, which is a fairly steep drop, and represents the seventh consecutive quarterly sales decline.
Why the Stock Is Selling Off
The reason why Wendy’s stock is falling is because investors appear to no longer be satisfied with the Wendy’s story. The company’s strategy has been to aggressively turn over restaurants to franchisees, which is a smart idea because it places most of the renovation and maintenance expenses onto the franchisee. In addition, Wendy’s is able to collect a more reliable stream of regular royalty income.
However, the flip side of Wendy’s franchising strategy is that total revenue will drop, as franchisees capture a greater portion of sales. This is exactly what happened last quarter, and it’s why the stock is performing poorly.
Investors appear concerned that even though margins are improving, the overall pie is shrinking. Franchising activity can only take a company so far; at some point, total revenue needs to grow again. That has been elusive for Wendy’s, as total revenue is down each quarter for almost two years.
What management needs to focus on now, more so than its franchising strategy, is the intensifying competition. Broadly speaking, the fast-food business is still rife with competition, with new players like Shake Shack (NASDAQ: SHAK) taking share. And, of course, there is the constant threat of fast-casual restaurants like Chipotle Mexican Grill (NASDAQ: CMG), which have capitalized on consumers’ desire for healthier eating options.
The Plan Going Forward
As a middle-tier fast-food chain, Wendy’s is getting squeezed on all sides.
Down the road, Wendy’s management remains fully committed to the franchising strategy. The company plans to reduce its restaurant ownership to 5% by the middle of next year. Longer term, it’s still on track to sell about 540 restaurants by the end of next year.
This is simply the same story, which no longer appears to impress investors. Presumably, this is because the stock market is a forward-looking mechanism, and investors are already seeing the end of the road for this strategy and are asking what comes next.
To be sure, Wendy’s has a plan outside of just more franchising. It is taking the fight directly to Chipotle by offering grilled chicken raised without antibiotics. Wendy’s has also emphasized its healthier options in its advertising, such as its salads. This is an attempt to directly take on Chipotle, which has thrived on the concept of organic foods and better-sourced ingredients.
Whether Wendy’s can begin to grow organically, and not just by franchising, remains to be seen.
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